Off with their heads

At last, the administration of US President Barack Obama seems to be contemplating a decisive move against the US’s banking elite. Following the recent electoral setback in Massachusetts the proposals laid down by former Federal Reserve chairman, Paul Volcker, to reduce the market power of the banks, are being dusted off.

Until now it has been a very different story – essentially a victory for the big bankers since spring 2009, when some of the healthier ones were allowed to start paying back any funds they had drawn from the US treasury’s Troubled Asset Relief Program. That, in turn, allowed them to escape even the very weak special conditions that had been laid down by the government relating to bonuses and remuneration.

At the critical moment of crisis and rescue – from September 2008 to early 2009 – the Bush and Obama administrations blinked. There was no serious thought of deposing the bankers, who had helped to cause the crisis, or of breaking up their banks.

Ordinarily, if an industry plunges into crisis, you expect a serious shake-up. Even if there was some bad luck mixed in with manifest incompetence, the presumption has generally been: if your company requires a government rescue, top management needs to be replaced. The US treasury has for many years consistently advocated such principles – both directly and through its influence with the International Monetary Fund (IMF) – when other countries have got into trouble.

But in the case of the US banking industry, nothing, at least until now, has happened at all. Most of the pre-crisis executives in big banks have remained in place, and very little has changed in terms of risk-control practices, or remuneration. Why was the administration so conservative? Fear of a complete collapse of the banking system must have played some role – along with an unhealthy degree of intermingling between the political and financial elite, which meant that there was real affection for firms such as Goldman Sachs and Citigroup at the top of government.

In any case, the window of opportunity appeared to have been missed. As the measures taken to stabilise the economy began to work, the banks started to make money again. And, given the departure of some competitors – such as Bear Stearns and Lehman Brothers – the larger market share for those that remained meant higher profits.

The administration did launch a modest regulatory-reform initiative in summer 2009, proposing new consumer protections and some measures to strengthen financial stability, but the measures were fought every inch of the way. And early in 2010 a new bank tax was proposed that aimed to raise about $90 billion (€64bn) over a decade or so – but that would have represented only about 1% of banks’ profits.

It is no surprise that the banks have tried to resist reform. The existing business model allows them to take the upside when they win, and hand over the downside to taxpayers when they lose. This encourages excessive risk and threatens repeated cycles of boom, bust, and bail-out. Indeed, Andrew Haldane, head of financial stability at the Bank of England, calls this our “doom loop”.

There was no serious thought of deposing the bankers, who had helped to cause the crisis, or of breaking up their banks.

Back-to-back international financial crises are rare, but the continued presence of such perverse incentives always leads to trouble – more than 50 years of IMF experience is clear on this point.

But, finally, after Massachusetts, it looks as if something important is happening. The reforms proposed by Volcker would impose restrictions on banks similar to those contained in the Glass-Steagall Act, the Depression-era legislation that separated commercial banking and investment banking. The dilution of Glass-Steagall, and its ultimate repeal in 1999, allowed banks to engage in so-called proprietary trading – enabling them to use depositors’ savings to trade for their own account, mainly in risky mortgage-backed securities.

But the Obama administration must go further than prohibiting proprietary trading by commercial banks and do two further things. First, capital requirements should be tripled – not just in the US, but across the G20 – so that banks hold at least 20%-25% of assets in core capital. That way, shareholders rather than regulators would play the leading role in making banks behave sensibly.

Second, if banks are ‘too big to fail’, they must be shrunk, so that taxpayers do not need to bail them out every time a crisis erupts. In the US context, the Riegle-Neal Interstate Banking Act of 1994, which set a size cap so that no bank can have more than 10% of retail deposits, needs to be amended. We need to update and enforce this sensible general notion and set a limit on how big any bank can become relative to the overall economy.

Obama is right to get tough with the six largest US banks – including JP Morgan Chase, Goldman Sachs, Citigroup, and Bank of America ¬– which now have total assets worth more than 60% of gross domestic product. This is an unprecedented degree of financial concentration. As Teddy Roosevelt pointed out more than 100 years ago, concentrated economic power tends to take over political power, which runs counter to the democratic tradition. We have now learned that it also runs counter to sound economic policy.